[Federal Register Volume 62, Number 176 (Thursday, September 11, 1997)]
[Notices]
[Pages 47845-47850]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-24039]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-39013; File No. SR-CBOE-97-28]


Self-Regulatory Organizations; Chicago Board Options Exchange, 
Inc.; Order Granting Approval to Proposed Rule Change and Notice of 
Filing and Order Granting Accelerated Approval of Amendment No. 1 to 
Proposed Rule Change Relating to Listing of Regular Options, Full and 
Reduced Value Long-Term Index Options, and FLEX Options on the Dow 
Jones Utility Average

September 3, 1997.

I. Introduction

    On June 23, 1997, the Chicago Board Options Exchange, Inc. 
(``CBOE'' or `` Exchange'') submitted to the Securities and Exchange 
Commission (``Commission''), pursuant to Section 19(b)(1) of the 
Securities Exchange Act of 1934 (``Act'') \1\ and Rule 19b-4 
thereunder,\2\ a proposed rule change to list regular options, full and 
reduced value long-term index options (``LEAPS''), and flexible 
exchange options (``FLEX'') on the Dow Jones Utility Average.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
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    The proposed rule change was published for comment in the Federal 
Register on July 8, 1997.\3\ No comments were received on the proposal. 
On August 12, 1997, the CBOE submitted

[[Page 47846]]

Amendment No. 1 to the proposed rule change.\4\ This order approves the 
proposal, as amended, and solicits comment on Amendment No. 1.
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    \3\ Securities Exchange Act Release No. 38790 (June 30, 1997), 
62 FR 36592 (July 8, 1997).
    \4\ In Amendment No. 1, the CBOE represents that it will notify 
the Commission if the Index fails to meet maintenance standards 
identical to those in CBOE Rule 24.2. In addition, Amendment No. 1 
states that the position limits for FLEX options will be set at 4 
times the limits applicable for industry index options set forth in 
Rule 24.4(A)(a)(i). Finally, Amendment No. 1, in an attached letter 
from Dow Jones, describes their procedures for replacing Index 
components and outlines their conflict of interest policy. See 
letter from Eileen Smith, Director, Product Development, CBOE to 
John Ayanian, Special Counsel, Division of Market Regulation, SEC 
dated August 1, 1997 (Amendment No. 1).
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II. Description of the Proposal

A. General

    The CBOE proposes to list and trade options on the Dow Jones 
Utility Average (``DJUA'' or ``Index''), an index developed by Dow 
Jones & Company. The options on the Index will be based on the full 
value of the Index. The CBOE also proposes to list LEAPS on a full 
value index level (``full value LEAPS'') and reduced-value LEAPS on the 
Index.\5\ For reduced-value LEAPS, the underlying value would be 
computed at one-tenth of the Index level. Reduced or full value LEAPS 
will trade independent of and in addition to regular Index options 
traded on the CBOE. The CBOE will also provide for the trading of FLEX 
Options on the Index.\6\
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    \5\ ``LEAPS'' is an acronym for Long-Term Equity Anticipation 
Securities. LEAPS are long-term index option series that expire from 
12 to 36 months from their date of issuance. See CBOE Rule 
24.9(b)(1).
    \6\ FLEX options are standardized options that provide investors 
with the ability to customize basic option features, including size, 
expiration date, exercise style, and exercise price.
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B. Composition of the Index

    The DJUA was first calculated on January 2, 1929, and is based on 
15 of the largest, most liquid U.S. utility industry stocks. All 
fifteen of the stocks in the Index currently trade on the New York 
Stock Exchange, Inc. (``NYSE'').\7\ All of the component stocks are 
``reported securities'' as that term is defined in Rule 11Aa3-1 of the 
Act.\8\ The Index is price weighted and will be calculated on a real-
time basis using last sale prices.
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    \7\ The DJUA currently consists of the following companies: 
American Electric Power Co., Inc., Columbia Gas System, Inc., 
Consolidated Natural Gas Co., Duke Power Co., Consolidated Edison 
Co. of New York, Edison International Inc., Enron Corp., Noram 
Energy Corp., PG and E Corp., Peco Energy Co., Public Service 
Enterprise Group, Inc., Southern Co., Texas Utilities Co., Unicom 
Corp. and Williams Companies, Inc.
    \8\ See 17 CFR 240.11Aa3-1. A ``reported security'' is defined 
in paragraph (a)(4) of this Rule as ``any listed equity security or 
NASDAQ security for which transaction reports are required to be 
made on a real-time basis pursuant to an effective transaction 
reporting plan.''
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    As of the close of trading on June 5, 1997, the Index had a closing 
value of 221.11.\9\ Also, as of the close of trading on June 5, 1997, 
the market capitalizations of the individual securities in the Index 
ranged from a high of $14.1 billion (Southern Co.) to a low of $2.1 
billion (Noram Energy Corp.), with a mean and median of $7.2 billion 
and $6.9 billion, respectively. The total market capitalization of the 
securities in the index was $107.5 billion. The total number of shares 
outstanding for the issuers in the index range from a high of 674 
million shares (Southern Co.) to a low of $5 million shares (Columbia 
Gas System, Inc.). The price per share of the securities in the Index 
ranged from a high of $65.75 (Columbia Gas System, Inc.) to a low of 
$15 (Noram Energy Corp.) with a six-month mean and median, for the 
period ending June 5, 1997 of $33.267 and $29, respectively. In 
addition, the average daily trading volume for securities in the Index 
ranged from a high of 1,261,386 shares (PG and E Corp.) to a low of 
203,472 shares (Columbia Gas System, Inc.), with the mean and median 
670,171 and 733,286, respectively. Lastly, no one security accounted 
for more than 13.18 percent of the Index's total value (Columbia Gas 
System, Inc.), and the percentage weighting of the five largest issues 
in the Index accounted for 49.81 percent of the Index's value. The 
percentage weighting of the lowest weighted component was 3.01 percent 
(Noram Energy Corp.) and the percentage weighting of the five smallest 
issues accounted for 20.07 percent of the Index's value. Finally, all 
of the component stocks in the Index are options eligible and currently 
the subject of trading in equity options.
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    \9\ The DJUA was first calculated on January 2, 1929 and the 
index value was 85.64 on that date.
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C. Maintenance

    Dow Jones & Company is responsible for maintenance of the DJUA. Dow 
Jones & Company may change the composition of the Index at any time to 
reflect the conditions in the utilities industry. The Managing Editor 
of the Wall Street Journal is responsible for component additions and 
deletions. The components of the Index are not formally reviewed on any 
set schedule. The Managing Editor of the Wall Street Journal selects 
stocks that he believes best reflect the utility sector of the economy 
and of the stock market. The Managing Editor usually consults one to 
three senior editors of The Wall Street Journal about prospective 
changes. Though various data might be gathered for reference, this is a 
subjective decision. Index maintenance includes monitoring and 
completing the adjustments for company additions and deletions, stock 
splits, stock dividends (other than an ordinary cash dividend), and 
stock price adjustments due to company restructuring or spinoffs. In 
almost all instances, a stock is removed immediately from the DJUA when 
the company files for protection under bankruptcy laws. If required, 
the Index Divisor will be adjusted to account for any of the above 
changes. Changes to the Index are announced in the Wall Street Journal 
and through the Dow Jones New Service generally two to three trading 
days prior to implementation. Generally, Index components are replaced 
infrequently. The Index is currently composed of 15 stocks and it is 
expected that it will remain at 15.
    The Exchange has represented that it will notify the Commission in 
the event that the following maintenance criteria are not met: (1) the 
market value of any component stock is less than $75 million except 
that the lowest weighted components comprising not more than 10% of the 
weight of the index cannot have market values less than $50 million; 
(2) less than 90% of the weight of the Index is represented by 
component stocks that are options eligible or less than 80% of the 
number of components are options eligible; (3) if any component stock 
trades less than 500,000 shares per month in each of the last 6 months, 
except that for the lowest weighted components comprising not more than 
10% of the weight of the index, volume must be at least 400,000 shares 
in each of the last 6 months; (4) the largest component stock accounts 
for more than 25% of the weight of the index or the largest 5 component 
stocks in the aggregate account for more than 60% of the weight of the 
index and (5) the number of stocks in the index is increased or 
decreased by more than \1/3\.

D. Applicability of CBOE Rules Regarding Index Options

    As modified herein, the rules in Chapter XXIV of the CBOE Rules 
will be applicable to DJUA Index options, full-value and reduced-value 
Index LEAPS and FLEX options. Those rules address, among other things, 
the applicable position and exercise limits, policies regarding trading 
halts and suspensions, and margin treatment for narrow-based index 
options.

[[Page 47847]]

E. Calculation of the Index

    The DJUA is a price-weighted index. The level of the Index reflects 
the total price of the component stocks divided by the Index Divisor. 
The daily calculation of the DJUA is computed by dividing the aggregate 
price of the companies in the Index by the Index Divisor. The Divisor 
keeps the Index comparable over time and is adjusted periodically to 
maintain the Index. The values of the Index will be calculated 
continuously by Dow Jones & Company or its designee and will be 
disseminated at 15-second intervals during regular CBOE trading hours 
to market information vendors via the Options Price Reporting Authority 
(``OPRA'') or the Consolidated Tape Association.

F. Contract Specifications

    The proposed options will be cash-settled, European-style 
options.\10\ The trading hours for options on the Index will be from 
8:30 a.m. to 3:02 p.m. Chicago time. Strike prices will be set to 
bracket the index in 2\1/2\ point increments or greater. In addition, 
pursuant to CBOE rule 24.9, there may be up to six expiration months 
outstanding at any given time. Specifically, there may be up to three 
expiration months from the March, June, September, and December cycle, 
plus up to three additional near-term months so that the two nearest-
term months will always be available. As described in more detail 
below, the Exchange also intends to list several Index LEAPS series 
that expire from 12 to 36 months from the date of issuance.
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    \10\ A European-style option can be exercised only during a 
specified period before the option expires.
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G. Settlement of Index Options

    The proposed options on the Index will expire on the Saturday 
following the third Friday of the expiration month. Trading in the 
expiring contract month will normally cease at 3:02 p.m. (Chicago time) 
on the business day preceding the last day of trading in the component 
securities of the Index (ordinarily the Thursday before expiration 
Saturday, unless there is an intervening holiday). The exercise 
settlement value of the Index at option expiration will be calculated 
by Dow Jones based on the opening prices of the component securities on 
the business day prior to expiration. If a stock fails to open for 
trading, the last available price on the stock will be used in the 
calculation of the index, as is done for currently listed indexes.\11\ 
When the last trading day is moved because of Exchange holidays (such 
as when CBOE is closed on the Friday before expiration), the last 
trading day for expiring options will be Wednesday and the exercise 
settlement value of Index options at expiration will be determined at 
the opening of regular Thursday trading.
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    \11\ The Commission notes that pursuant to Article XVII, Section 
4 of the Options Clearing Corporation's (``OCC'') by-laws, OCC is 
empowered to fix an exercise settlement amount in the event it 
determines a current index value is unreported or otherwise 
unavailable. Further, OCC has the authority to fix an exercise 
settlement amount whenever the primary market for the securities 
representing a substantial part of the value of an underlying index 
is not open for trading at the time when the current index value 
(i.e., the value used for exercise settlement purposes) ordinarily 
would be determined. See Securities Exchange Act Release No. 37315 
(June 17, 1996), 61 FR 42671 (order approving SR-OCC-95-19).
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H. Listing of Long-Term Options on the Full-Value or Reduced Value DJUA 
Index

    The Exchange's proposal provides that the Exchange may list longer 
term option series having up to thirty-six months to expiration on the 
Index's full value. In lieu of such long-term options on a full value 
Index level, the Exchange may instead list long-term, reduced value put 
and call options based on one-tenth (\1/10\th) the Index's full value. 
The current and closing index value of any such reduced-value LEAP 
will, after initial computation, be rounded to the nearest one-
hundredth. In either event, the interval between expiration months for 
either a full value or reduced long-term option will not be less than 
six months. The trading of any longer term options would be subject to 
the same rules which govern the trading of all Exchange's index 
options, including sales practice rules, margin requirements and floor 
trading procedures and all options will have European-style exercise.

I. FLEX Option Trading

    The Exchange proposes to list FLEX Index options on the DJIA. FLEX 
options give investors the ability, within specified limits, to 
designate certain of the terms of the options. In recent years, an 
over-the-counter (``OTC'') market in customized options has developed 
which permits participants to designate the basic terms of the options, 
including size, term to expiration, exercise style, exercise price, and 
exercise settlement value, in order to meet their individual investment 
needs. Participants in this OTC market are typically institutional 
investors, who buy and sell options in large-size transactions through 
a relatively small number of securities dealers. To compete with this 
growing OTC market in customized options, the CBOE permits FLEX index 
options trading in an exchange auction market environment, with OCC as 
issuer and guarantor.\12\ The Exchange's proposal will allow FLEX 
option market participants to designate the following contract terms 
for FLEX options on the DJUA: (1) Exercise price; (2) exercise style 
(i.e., American,\13\ European,\14\ or capped \15\); (3) expiration 
date; \16\ (4) option type (put, call, or spread); and (5) form of 
settlement (A.M., P.M. or average).
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    \12\ The Commission has previously designated FLEX index options 
as standardized options for the purposes of the options disclosure 
framework established under Rule 9b-1 of the Act. See Securities 
Exchange Act Release No. 31910 (February 23, 1993), 58 FR 12056 
(March 2, 1993). In addition, the Commission has approved the 
listing by CBOE of FLEX Index options on the S&P 100 (``OEX''), S&P 
500 (``SPX''), Nasdaq 100, and Russell 2000 Indexes. See Securities 
Exchange Act Release Nos. 31920 (February 24, 1993), 58 FR 12280 
(March 3, 1993) (approval of FLEX options on the SPX and OEX 
indexes); 34052 (May 12, 1994), 59 FR 25972 (May 18, 1994) (approval 
of FLEX options on the Nasdaq 100 index); and 32694 (July 29, 1993), 
58 FR 41814 (August 5, 1993) (approval of FLEX options on the 
Russell 2000 index).
    \13\ An American-style option is one that may be exercised at 
any time on or before the expiration date.
    \14\ A European-style option is one that may be exercised only 
during a limited period of time prior to expiration of the option.
    \15\ A capped-style index option is one that is automatically 
exercised prior to expiration when the cap index value is less than 
or equal to the index value for calls or when the cap index value is 
greater than or equal to the index value for puts.
    \16\ The expiration date of a FLEX option may not fall on a day 
that is on, or within two business days, of the expiration date of a 
Non-FLEX option.
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    The Exchange is proposing changes to its FLEX rules to provide for 
the trading of FLEX options on the DJUA. The proposed changes include 
an amendment to the FLEX Option position limits. Position limits would 
be as established by the Exchange but in no event would be greater than 
four times the limits for standard options on the DJUA.\17\
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    \17\ See Amendment No. 1, supra note 4.
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J. Position and Exercise Limits, Margin Requirements, and Trading Halts

    The proposal provides that Exchange rules that are applicable to 
the trading of narrow-based index options will apply to the trading of 
options on the Index. Specifically, Exchange rules governing margin 
requirements, \18\

[[Page 47848]]

position and exercise limits, \19\ and trading halt procedures \20\ 
that are applicable to trading of narrow-based index options will apply 
to options traded on the Index. Position limits on reduced value long-
term DJUA Index options will be equivalent to the position limits for 
regular (full value) Index options and would be aggregated with such 
options (for example, if the position limit for the full value options 
is 15,000 contracts on the same side of the market, then the position 
limit for the reduced value options will be 150,000 contracts on the 
same side of the market).
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    \18\ Pursuant to CBOE Rule 24.11, the margin requirements of the 
Index options will be: (1) for short positions, 100% of the current 
market value of the options contract plus 20% of the underlying 
aggregate Index value, less any out-of-the-money amount, with a 
minimum requirement of the options premium plus 10% of the 
underlying Index value; and (2) for long term options positions, 
100% of the options premium paid.
    \19\ Pursuant to CBOE Rules 24.4A and 24.5, respectively, the 
position and exercise limits for the Index options will be 15,000 
contracts, unless the Exchange determines, pursuant to Rules 24.4A 
and 24.5 that a lower limit is warranted.
    \20\ Pursuant to CBOE Rule 24.7, the trading of options on the 
Index will be halted or suspended whenever trading in underlying 
securities whose weighted value represents more than 20% of the 
Index's value is halted or suspended.
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K. Surveillance

    Surveillance procedures currently used to monitor trading in each 
of the Exchange's other index options will also be used to monitor 
trading in options on the Index. These procedures include complete 
access to trading activity in the underlying securities. Further, the 
Intermarket Surveillance Group (``ISG'') Agreement, dated July 14, 
1983, as amended on January 29, 1990, will be applicable to the trading 
of options on the Index.\21\
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    \21\ ISG was formed on July 14, 1983 to, among other things, 
coordinate more effectively surveillance and investigative 
information sharing arrangements in the stock and options markets. 
See Intermarket Surveillance Group Agreement, July 14, 1983. The 
most recent amendment to the ISG Agreement, which incorporates the 
original agreement and all amendments made thereafter, was signed by 
ISG members on January 29, 1990. See Second Amendment to the 
Intermarket Surveillance Group Agreement, January 29, 1990. The 
members of the ISG are: the American Stock Exchange, Inc.; the 
Boston Stock Exchange, Inc.; the CBOE; the Chicago Stock Exchange, 
Inc.; the National Association of Securities Dealers, Inc.; the 
NYSE; the Pacific Stock Exchange, Inc.; and the Philadelphia Stock 
Exchange, Inc. Because of potential opportunities for trading abuses 
involving stock index futures, stock options, and the underlying 
stock, and the need for greater sharing of surveillance information 
for these potential intermarket trading abuses, the major stock 
index futures exchanges (e.g., the Chicago Mercantile Exchange and 
the Chicago board of Trade) joined the ISG as affiliate members in 
1990.
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    Dow Jones & Company also has a policy in place to prevent the 
potential misuse of material, non-public information by members of the 
Wall Street Journal managerial and editorial staff in connection with 
the maintenance of the Index. Specifically, the managerial and 
editorial staff of the Wall Street Journal are subject to the Dow Jones 
& Company conflicts-of-interest policy which prohibits, upon penalty of 
dismissal, the use or dissemination of any vital information prior to 
publication.\22\
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    \22\ See Amendment No. 1, supra note 4.
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III. Findingcard Conclusions

    The Commission find that the proposed rule change is consistent 
with the requirements of the Act and the rules and regulations 
thereunder applicable to a national securities exchange,\23\ and, in 
particular, with the requirements of Section 6(b)(5).\24\ Specifically, 
the Commission finds that the trading of options on the Index, 
including full-value and reduced value Index LEAPS and FLEX options, 
will serve to promote the public interest and help to remove 
impediments to a free and open securities market by providing investors 
with an additional means to hedge exposure to market risk associated 
with stocks in the utility sector.\25\ The trading of options in the 
DJUA, however, raises several issues relating to index design, investor 
protection, surveillance, and market impact. The Commission believes, 
for the reasons discussed below, that the CBOE has adequately addressed 
the issues.
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    \23\ In approving this rule, the Commission has considered the 
proposed rule's impact on efficiency, competition, and capital 
formation. 15 U.S.C. Sec. 78c(f).
    \24\ 15 U.S.C. 78f(b)(5).
    \25\ Pursuant to Section 6(b)(5) of the Act, the Commission must 
predicate approval of any new option proposal upon a finding that 
the introduction of such new derivative instrument is in the public 
interest. Such a finding would be difficult for a derivative 
instrument that served no hedging or other economic function, 
because any benefits that might be derived by market participants 
likely would be outweighed by the potential for manipulation, 
diminished public confidence in the integrity of the markets, and 
other valid regulatory concerns. In this regard, the trading of 
listed options on the Index will provide investors with a hedging 
vehicle that should reflect the overall movement of the stocks 
representing companies in the utility sector in the U.S. stock 
markets.
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A. Index Design and Structure

    The DJUA is comprised of only fifteen stocks, all of which are 
within one industry segment, the utility industry segment. Accordingly, 
the Commission believes that it is appropriate for the CBOE to apply 
its rules governing narrow-based index options to trading in the Index 
options including for margin and position and exercise limit 
purposes.\26\
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    \26\ See supra notes 18 through 20, and accompanying text.
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    The Commission also believes that the liquid markets, large 
capitalizations, and relative weightings of the index's component 
stocks significantly minimize the potential for manipulation of the 
Index. First, as of June 5, 1997, the overwhelming majority of the 
stocks that comprise the Index are actively traded, with a mean and 
median daily trading volume 670,171 and 733,268 shares, 
respectively.\27\ Second, the market capitalizations of the stocks in 
the Index are very large, ranging from $2.1 billion to $14.1 billion, 
with the mean and median being $7.2 billion and $6.9 billion, 
respectively. Third, although the Index is only comprised of fifteen 
component stocks, no one stock or group of stocks dominates the Index. 
Specifically, no one stock comprises more than 13.18% of the Index 
total value and the percentage weighting of the five largest issues in 
the Index accounts for 49.81% of the Index's value. Fourth, all of the 
stocks in the Index are currently the subject of equity options 
trading.\28\ Fifth, the Exchange has represented that it will notify 
the Commission in the event that the following maintenance criteria are 
not met: (1) the market value of any component stock is less than $75 
million except that the lowest weighted components comprising not more 
than 10% of the weight of the index cannot have market values less than 
$50 million; (2) less than 90% of the weight of the Index is 
represented by component stocks that are options eligible or less than 
80% of the number of components are options eligible; (3) if any stock 
trades less than 500,000 shares per month in each of the last 6 months, 
except that for the lowest weighted components comprising not more than 
10% of the weight of the index, volume must be at least 400,000 shares 
in each of the last 6 months; (4) the largest component stock accounts 
for more than 25% of the weight of the index or the largest 5 component 
stock accounts for more than 25% of the weight of the index or the 
largest 5 component stocks in the aggregate account for more than 60% 
of the weight of the index; and (5) the number of stocks in the index 
is increased or decreased by more than \1/3\. In the event the Index 
fails to satisfy any of the

[[Page 47849]]

criteria, CBOE will notify the Commission to determine the appropriate 
regulatory response, including but not limited to, prohibiting opening 
transactions, removal of the securities from the Index, or 
discontinuing the listing of new series of Index options.\29\ These 
maintenance standards should help protect against material changes in 
the composition and design of the Index that might adversely affect the 
CBOE's obligations to protect investors and to maintain fair and 
orderly markets in DJUA Index options.\30\ Finally, the Commission 
believes these factors minimize the potential for manipulation because 
it is unlikely that attempted manipulations of the prices of the Index 
components would affect significantly the Index's value. Moreover, the 
surveillance procedures discussed below should detect as well as deter 
potential manipulation and other trading abuses.\31\
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    \27\ In addition, for the six-month period ending June 5, 1997, 
all of the companies comprising the Index had an average daily 
trading volume of at least 203,472 shares per day.
    \28\ The CBOE's options listing standards, which are uniform 
among the options exchanges, provide that a security underlying an 
option must, among other things, meet the following requirements: 
(1) the public float must be at least 7,000,000; (2) there must be a 
minimum of 2,000 stockholders' (3) trading volume must have been at 
least 2.4 million over the preceding twelve months; and (4) the 
market price must have been at least $7.50 for a majority of the 
business days during the preceding three calendar months. See CBOE 
Rule 5.3.
    \29\ In addition, if the composition of the Index's underlying 
securities was to substantially change, the Commission's decision 
regarding the appropriateness of the Index's current maintenance 
standards would be reevaluated, and whether additional approval 
under Section 19(b) of the Act is necessary to continue to trade the 
product.
    \30\ These maintenance standards are similar to those applied to 
other index products. See CBOE Rule 24.2(c).
    \31\ The Commission believes that, even though the Index is 
price weighted, the high capitalization and active trading of the 
component stocks minimize any manipulative concerns that may arise 
due to the price weighting.
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B. Customer Protection

    The Commission believes that a regulatory system designed to 
protect public customers must be in place before the trading of 
sophisticated financial instruments, such as options on the Index, can 
commence on a national securities exchange. The Commission notes that 
the trading of standardized exchange-traded options occurs in an 
environment that is designed to ensure, among other things, that: (1) 
the special risks of options are disclosed to public customers; (2) 
only investors capable of evaluating and bearing the risks of options 
trading are engaged in such trading; and (3) special compliance 
procedures are applicable to options accounts. Accordingly, because 
options on the Index will be subject to the same regulatory regime as 
the other standardized options currently traded on the CBOE, the 
Commission believes that adequate safeguards are in place to ensure the 
protection of investors in options on the Index. Finally, replacements 
of component securities in the Index are published in the Wall Street 
Journal two to three trading days before they are implemented to notify 
the public of changes in the composition of the Index. The Commission 
believes this should help to protect investors and avoid investor 
confusion.

C. Surveillance

    The Exchange believes that a surveillance sharing agreement between 
an exchange proposing to list a stock index derivative product and the 
exchange(s) trading the stocks underlying the derivative product is an 
important measure for surveillance of the derivative and underlying 
securities markets. Such agreements ensure the availability of 
information necessary to detect and deter potential manipulations and 
other trading abuses, thereby making the stock index product less 
readily susceptible to manipulation.\32\ In this regard, markets on 
which all of the components of the Index currently trade are members of 
the ISG, which provides for the exchange of all necessary surveillance 
information.\33\
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    \32\ See Securities and Exchange Act Release No. 31243 
(September 28, 1992), 57 FR 45849 (October 5, 1992).
    \33\ See supra note 21 and accompanying text.
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    As noted above, Dow Jones & Company also has a policy in place to 
prevent the potential misuse of material, non-public information by 
members of the Wall Street Journal managerial and editorial staff in 
connection with the maintenance of the Index.\34\
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    \34\ See Amendment No. 1, supra note 4.
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D. Market Impact

    The Commission believes that the listing and trading of options on 
the Index, including long-term full-value and reduced-value Index 
options and FLEX options, on the CBOE will not adversely impact the 
underlying securities markets.\35\ First, as described above, due to 
the ``price weighting'' methodology, no one stock or group of stocks 
dominates the Index. Second, as noted above, the stocks contained in 
the Index have relatively large capitalizations and are relatively 
actively traded. Third, the currently applicable 15,000 contract 
position and exercise limits will serve to minimize potential 
manipulation and market impact concerns. Fourth, the risk to investors 
of contraparty non-performance will be minimized because the options on 
the Index will be issued and guaranteed by OCC just like any other 
standardized exchange-listed option traded in the United States.
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    \35\ In addition, CBOE and OPRA have represented that CBOE and 
OPRA have the necessary systems capacity to support those new series 
of index options that would result from the introduction of options 
on the Index. See Letter from Joe Corrigan, Executive Director, 
OPRA, to Eileen Smith, Director of Research and Product Development, 
CBOE, dated June 12, 1997.
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    Lastly, the Commission believes that settling expiring options on 
the Index (including long-term full-value and reduced-value Index 
options) based on the opening prices of component securities is 
reasonable and consistent with the Act. As noted in other contexts, 
valuing options for exercise settlement on expiration based on opening 
prices rather than closing prices may help reduce adverse effects on 
markets for stocks underlying options on the Index.\36\
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    \36\ Securities and Exchange Act Release No. 30944 (July 21, 
1992), 57 FR 33376 (July 28, 1992).
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E. FLEX Options Trading

    The Commission also believes that the proposal to list DJUA FLEX 
options should encourage fair competition among brokers and dealers and 
exchange markets, by allowing the Exchange to compete with the growing 
OTC market in customized index options.
    The Commission believes the Exchange's proposal reasonably 
addresses its desire to meet the demands of sophisticated portfolio 
managers and other institutional investors who are increasingly using 
the OTC market in order to satisfy their hedging needs. Additionally, 
the Commission believes that the Exchange's proposal will help promote 
the maintenance of a fair and orderly market, consistent with Sections 
6(b)(5) and 11(a) of the Act, because the purpose of the proposal to 
list DJUA FLEX options is to extend the benefits of a listed, exchange 
market to index options that are more flexible than current listed 
options and that currently trade OTC.\37\ The benefits of the 
Exchange's options market include, but are not limited to, a 
centralized market center, an auction market with posted transparent 
market quotations and transaction reporting, parameters and procedures 
for clearance and settlement, and the guarantee of OCC for all 
contracts traded on the Exchange.
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    \37\ As noted above, FLEX options allow investors to customize 
certain terms, including size, term to expiration, exercise style, 
exercise price, and exercise settlement value.
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    The Commission notes that FLEX index options on the DJUA can be 
constructed with expiration exercise settlement based on the closing 
values of the component securities, which could potentially result in 
adverse effects for the markets in these

[[Page 47850]]

securities.\38\ Although the Commission continues to believe that 
basing the settlement of index products on opening as opposed to 
closing prices on Expiration Friday helps alleviate stock market 
volatility,\39\ these market impact concerns are reduced in the case of 
FLEX options on the DJUA because expiration of these options will not 
correspond to the normal expiration of any non-FLEX options (including 
options overlying the DJUA), stock index futures, and options on stock 
index futures. In particular, FLEX options, will never expire on any 
``Expiration Friday'' because the expiration date of a FLEX option may 
not occur on a day that is on, or within, two business days of the 
expiration date of a Non-FLEX option. The Commission believes that this 
should reduce the possibility that the exercise of FLEX options at 
expiration will cause any additional pressure on the market for 
underlying securities at the same time that Non-FLEX options expire.
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    \38\ See, e.g., Securities Exchange Act Release No. 30944 (July 
21, 1992), 57 FR 33376 (July 28, 1992).
    \39\ Id.
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    Nevertheless, because the position limits for FLEX index options on 
the DJUA are much higher than those currently proposed for the 
corresponding non-FLEX Index options (i.e., 4 times the existing 15,000 
contract limit) and open interest in one or more FLEX option series 
could grow to significant levels, it is possible that FLEX options on 
the DJUA might have an impact on the securities markets for the 
securities underlying FLEX options. The Commission expects the Exchange 
to monitor the actual effect of FLEX options on the DJUA once trading 
commences and take prompt action (including timely communication with 
the self-regulatory organizations responsible for oversight of trading 
in the underlying securities) should any unusual market effects 
develop.

F. Accelerated Approval of Amendment No. 1

    The Commission finds good cause for approving Amendment No. 1 to 
the proposed rule change prior to the thirtieth day after the date of 
publication of notice of filing thereof in the Federal Register. 
Amendment No. 1, does raise any novel issues. It merely states that the 
Exchange will notify the Commission in the event that the Index fails 
to meet a set of maintenance standards that are substantially similar 
to existing maintenance standards for narrow-based indices. These 
representations are identical in all material respects to those made by 
the Exchange in connection with similar proposals to list options on 
stock indexes. In addition, Amendment No. 1 sets position limits for 
FLEX options at 4 times the limits applicable for industry index 
options and includes an attached letter from Dow Jones & Company 
describing their procedures for replacing Index components and 
outlining their conflict of interest policy. The Commission believes, 
therefore, that Amendment No. 1 further strengthens and clarifies the 
proposal, and raises no new regulatory issues. Further, the Commission 
notes that the original proposal was published for the full 21-day 
comment period and no comments were received by the Commission. 
Accordingly, the Commission believes it is consistent with Sections 
19(b)(2) and 6(b)(5) of the Act to approve Amendment No. 1 to the 
Exchange's proposal on an accelerated basis.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views and 
arguments concerning Amendment No. 1. Persons making written 
submissions should file six copies thereof with the Secretary, 
Securities and Exchange Commission, 450 Fifth Street, N.W., Washington, 
D.C. 20549. Copies of the submission, all subsequent amendments, all 
written statements with respect to the proposed rule change that are 
filed with the Commission, and all written communications relating to 
the proposed rule change between the Commission and any person, other 
than those that may be withheld from the public in accordance with the 
provisions of 5 U.S.C. 552, will be available for inspection and 
copying at the Commission's Public Reference Room. Copies of such 
filing will also be available for inspection and copying at the 
principal office of the above-mentioned self-regulatory organization. 
All submissions should refer to File No. SR-CBOE-97-28 and should be 
submitted by October 2, 1997.

V. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\40\ that the proposed rule change (SR-CBOE-97-28) is approved, as 
amended. In addition, for purposes of trading FLEX options on the 
Index, the Commission also finds, pursuant to Rule 9b-1 under the Act, 
that such options are standardized options for purposes of the options 
disclosure framework established under Rule 9b-1.

    \40\ 15 U.S.C. 78s(b)(2).
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    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\41\
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    \41\ 17 CFR 200.30-3(a) (12) and (51).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 97-24039 Filed 9-10-97; 8:45 am]
BILLING CODE 8010-01-M